How to buy ... investment real estate

Beating a path to income-producing property, and what to avoid

CHICAGO (MarketWatch) — Investing in real estate most likely won't produce the get-rich-quick results promised by many a late-night infomercial. But for investors willing to do some homework, make a good purchase and properly manage a piece of property, the rewards can be substantial.

Various strategies can be used on the road to real estate wealth. In one, investors "flip" properties by buying a house, renovating it in short order and selling for a profit. In another, investors purchase the property with the intent to hold it for many years.

A common approach is to purchase an income-producing property such as a single-family home, an apartment building, an office or retail building or farmland with the intent to rent the property or units within it. By having tenants, investors benefit not only from any appreciation over time but also the rental cash flow. There's also some inflation protection because as operating costs increase, rents can increase as well.

The downside: Investment in real property — unless you're buying shares in a real estate investment trust — isn't as liquid as putting money into the stock market. And real estate markets are often cyclical in nature.

In fact, those adverse to the risks involved with purchasing property may consider a REIT instead to add real estate to their portfolios. A REIT takes the management issue out of the equation, provides more liquidity, can spread risk geographically and also is income producing — REITs, publicly traded companies that own and manage real estate, are required to pay out at least 90% of their taxable income as dividends.

What to watch for:

First, consider what kind of expertise you bring to the table. For example, contractors can renovate a property; lawyers might write up leases.

"Everyone brings a certain amount of sweat equity," said Kyle Cascioli, an adjunct professor of real estate at the University of Denver's Burns School of Real Estate and Construction Management.

Or maybe your value is on the management side. Those thinking about becoming landlords should do some soul searching before deciding whether they can handle the job, said Thomas Lucier, a Florida-based real estate investor and author of "The No-Nonsense Real Estate Investor's Kit." Nine out of 10 people aren't suited for the business of managing tenants or the constant upkeep that the property will require, he said.

And for an investor with a modestly sized piece of real estate, hiring a separate property manager can eat deeply into the bottom line, said Rebecca McLean, executive director of the National Real Estate Investors Association. After all, income-producing real estate isn't just an investment — it's a small business.

You'll want to tap the knowledge of a local real estate professional for help in finding and evaluating an investment property, McLean said. It's best to contact a broker or Realtor who works regularly with investors, she added.

Alternately, it's possible to go it alone, but get ready to do some research.

Location will always impact the value of any piece of real estate. In residential properties, the health of the local economy and school district are necessary considerations. Meaningful due diligence is also required on commercial properties; leases usually span longer than a year, and research on current tenants is a must.

Deciding whether the property is affordable involves a little more homework.

Budget every cost that will be tacked on to the price, including closing costs and insurance. If the property is a fixer-upper, inspections should prove its structure is still sound; make sure to add improvement estimates into the equation, including a cushion for unforeseen extras.

Just as important as having a plan to enter the market: having an exit strategy. Investors should estimate how long they expect to hold the asset, said Joseph Fisher, president of Indianapolis-based Real Estate Investment Services Corp., which specializes in developing, leasing and managing investment real estate.

And despite the income scheduled to hit the books each month, don't plan to keep every dime, said Lisa Moren, an Oakland, Calif.-based real estate investor and author of "Real Estate Investing for The Utterly Confused." Moren advises having an escrow account for required fixes that pop up and disruptions in cash flow resulting from vacancies.

What to watch out for:

Overpaying for the property

Good research is the key to avoiding this mistake. "You make your profit when you buy, in most cases, because you buy below market value," Lucier said. Some investors can profit by buying properties that need a little work. Properties that have positive cash flow without any required repairs may have other areas for improvement, which make mismanaged properties attractive investments, Lucier said.

Overlooking rules and regulations

Rules abound in the housing sector, from federal fair housing regulations to laws that spell out how lead paint is to be disclosed. The fines for noncompliance can be hefty, so do your homework, McLean said. Also, be aware of a property's building code issues.

Not screening for good tenants

Check tenants' credit and their employment to make sure they can afford the monthly payments. Also, the longer a tenant stays the better. Every time a renter moves out and a new one moves in, it costs about two-and-a-half months' worth of rent -- "whether in marketing, down time and/or repairs to the property," McLean said. The figure assumes that there isn't severe damage to the premises.

Taking on too much, too soon

You may want to start small, perhaps with a duplex, to decide whether this type of investment works for you, Lucier said. Also, don't go overboard on improvements. Major spending in areas that won't provide a decent rate of return on investment cuts into your bottom line, McLean said.

Entering into a bad partnership

Many investors partner with others to afford a purchase, but you'd better be comfortable with the arrangement, Fisher said. Sometimes a partnership teams up a novice with a real estate professional who has knowledge of the business. Especially for the newcomer in this scenario, review a real estate investor's past performance before agreeing to work together.

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